Financial crisis could turn the tide against unrestricted capital flows

Boom-bust pattern has meant even IMF and Bank of England are rethinking regulation

Alan Greenspan, left, was an advocate of the free cross-border flow of capital when head of the US Federal Reserve while the Bank of England under Mervyn King, right, has been an unlikely champion of regulation. Photograph: Pablo Martinez Monsivais/AP

Watching as the Spanish government announced drastic new austerity measures, you could have been forgiven for thinking that neoliberal orthodoxy holds sway almost as decisively as when Alan Greenspan was the maestro of the Federal Reserve.

But away from Brussels, one element at least of the neoliberal canon – the idea that capital must be allowed to flow unchecked around the world – is coming under sustained attack.

The theory says that free capital flows allow savings to be directed – by the invisible hand of the financial markets – to wherever they will be most profitably employed. In this way, savers get a better return on their nest egg, while underdeveloped economies receive the financial leg-up they need. And as firms from one country take over those of another, they bring much-needed expertise as well as help new ideas to be adopted rapidly worldwide.

Except that isn't what's been happening: instead, for the past decade and more, savings have been pouring uphill from poor countries to rich. Whether you call it a savings glut or a borrowing binge (two sides of the same coin), it has led to a flood of money sluicing through financial markets, looking for a home. And far from nurturing development and improving the standard of living of the poorest, these vast flows of money have created a repeated pattern of boom, bust and financial crisis.

When the climate is "risk on", as they say in Wall Street and Canary Wharf, capital rains down on the fashionable economies of the moment. But a change in mood – or an increase in interest rates in Washington, say – can, like the proverbial flap of a distant butterfly wing, unleash an economic storm as capital floods back out again.

A recent paper by thinktank the Bretton Woods Project, Time for a New Consensus, enumerates five major threats of unregulated capital flows. There is currency risk, because large inflows can push up a country's exchange rate (you need to buy Turkish lira if you want to buy a firm in Istanbul). An overvalued currency undermines domestic exporters and leaves them unable to compete. There is flight risk, because funds often leave as rapidly as they arrive, pulling the rug out from under local businesses and stunting economic growth.

Contagion risk is the threat that close financial links between economies means a shock in one can drag everyone down – as shown by the devastating knock-on effects of the US sub-prime crisis over the past four years.

Fragility risk occurs when an economy becomes heavily dependent on borrowing from overseas, often in foreign currencies. Hungarian households took out mortgages in euros in the runup to the credit crisis, for example, as their country prepared to join the single currency. That meant the sharp decline in the forint took a severe economic and social toll when the crisis hit, as the loans spiralled in value relative to homeowners' wages.

Finally, sovereignty risk, chillingly familiar to a string of crisis-hit countries across the world in the past two decades, is the threat that instead of overseas investment giving governments the resources they need to improve the livelihoods of their population, politicians are left with little or no control over their own economies. Increasing domestic interest rates to control an unsustainable boom has little impact if cut-price capital keeps flooding in.

Not surprisingly, large developing countries have long been suspicious of the west's insistence that its banks and corporations must be allowed to bestride the world, unrestrained by government interference.

The World Trade Organisation summit in Cancún in 2003, part of the now dormant Doha round, collapsed because the rich world insisted that the so-called Singapore issues, which included removing restrictions on foreign investment, must be part of any bargain. Developing countries objected so vehemently they walked out.

Since the onset of the credit crunch in 2007, those countries – including China and India – that have kept tight control over financial inflows have fared better than those that have thrown open their borders.

And in recent years, several countries have quietly begun erecting breakwaters against the latest tidal wave of capital, driven by low interest rates in the west. Brazil, Argentina and Costa Rica have used various measures, including taxes on purchases of shares and bonds and insisting that short-term investors deposit funds with the central bank for a year, to dampen the stop-go cycle.

It doesn't mean no investment; just trying to discriminate between long-term capital that will help to deliver jobs and sustainable growth and the short-term whims of the herd.

The International Monetary Fund responded to growing pressure for a rethink last year and issued two papers acknowledging that regulations on capital flows could be useful. But it suggested their use should be restricted to crises and governed by a strict code of conduct. That idea was rejected by emerging economies, which are wielding growing influence at the Washington-based lender. The G20, a forum in which China, India and Brazil have a strong voice, issued its own far more radical study in October. The tide is turning.

One unlikely recent champion of the reintroduction of regulations on capital flows is the Bank of England. The shock of being caught unawares by the vulnerability of the UK's financial system in 2007 and 2008 caused soul-searching in Threadneedle Street, and recent papers and speeches have helped build the case for new thinking.

Two research studies in particular, released last month, suggested cross-border flows of capital will increase radically in the coming years as developing countries grow in size; that the UK will be particularly vulnerable to future sudden reversals in these flows, because of its vast external balance sheet; and that the international community should consider drawing up a set of rules governing how and when countries can act to protect themselves.

If there's one thing policymakers should have learned over the past four years, it's that financial markets can't be left to run the world themselves.